Midterm 1

Question 1

National Income Accounting

Answer 1

The Measurement of Production, Income, and Expenditure
 National income accounts: an accounting framework used in measuring current economic
activity

Question 2

GDP (gross domestic product)

Answer 2

the market value of final goods and services newly

produced within a nation during a fixed period of time

Question 3

Three alternative approaches give the same measurements

Answer 3

Product approach: the amount of output produced

2. Income approach: the incomes generated by production
3. Expenditure approach: the amount of spending by purchasers

Question 4

Why are the three approaches equivalent?

Answer 4

They must be, by definition
 Any output produced (product approach) is purchased by someone (expenditure
approach) and results in income to someone (income approach)
 The fundamental identity of national income accounting:
 total production = total income = total expenditure

Question 5

The product approach to measuring GDP

Answer 5

Market value: allows adding together unlike items by valuing them at their market prices
 Problem: misses nonmarket items such as homemaking, the value of environmental
quality, and natural resource depletion
 Does not reflect the underground economy
 Newly produced: counts only things produced in the given period; excludes things produced
earlier
 Incudes only final goods and services
 Don’t count intermediate goods and services (those used up in the production of other
goods and services in the same period that they themselves were produced)

 Final goods & services are those that are not intermediate
 Capital goods (goods used to produce other goods) are final goods since they aren’t used
up in the same period that they are produced
 Inventory investment (the amount that inventories of unsold finished goods, goods
in process, and raw materials have changed during the period) is also treated as a final
good.
 Adding up value added works well, since it automatically excludes intermediate goods

Question 6

GNP vs. GDP

Answer 6

GNP (gross national product) = output produced by domestically owned factors of
production
 GDP = output produced within a nation
 GDP = GNP − NFP (net factor payments from abroad)

Question 7

NFP

Answer 7

payments to domestically owned factors located abroad minus payments
to foreign factors located domestically

Question 8

The expenditure approach to measuring GDP

Answer 8

Measures total spending on final goods and services produced within a nation during a
specified period of time

Question 9

Four main categories of spending:

Answer 9

consumption (C), investment (I), government purchases of

goods and services (G), and net exports (NX)

Question 10

the income–expenditure identity

Answer 10

Y = C + I + G + NX

Question 11

Consumption

Answer 11

spending by domestic households on final goods and services
(including those produced abroad)
 About 2/3 of U.S. GDP

Question 12

Three categories of Consumption

Answer 12

Consumer durables (examples: cars, TV sets, furniture, and major appliances)
Nondurable goods (examples: food, clothing, fuel)
Services (examples: education, health care, financial services, and transportation)

Question 13

Investment

Answer 13

(Gross domestic private investment): spending for new capital goods (fixed
investment) plus inventory investment
 Volatile, with fixed investment about 13% to 20% of U.S. GDP
 Business (or nonresidential) fixed investment: spending by businesses on structures,
equipment, and intellectual property products, such as software, research and
development, or artistic originals
 Residential fixed investment: spending on the construction of houses and apartment
buildings
 Inventory investment: increases in firms’ inventory holdings

Question 14

Government purchases of goods and services

Answer 14

spending by the government on goods or
services
 About 1/5 of U.S. GDP
 Most by state and local governments, not federal government
 Some government spending is for capital goods also called gross domestic public
investment, such as highways, airports, bridges, and water and sewer systems
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 Not all government expenditures are purchases of goods and services
Some are payments that are not made in exchange for current goods and services and
therefore NOT included in GDP
Example: Social Security payments, welfare, and unemployment benefits

Question 15

Net exports

Answer 15

exports minus imports
 Exports: goods produced in the country that are purchased by foreigners
 Imports: goods produced abroad that are purchased by residents in the country
 Imports are subtracted from GDP, as they represent goods produced abroad, and were
implicitly included in consumption, investment, and government purchases

Question 16

 The income approach to measuring GDP

Answer 16

Adds up income generated by production (including profits and taxes paid to the government)
 National income = compensation of employees (including benefits) + proprietors’
income + rental income of persons + corporate profits + net interest + taxes on production
and imports + business current transfer payments + current surplus of government
enterprises
 National income + statistical discrepancy = net national product
 Net national product + depreciation (the value of capital that wears out in the period) =
gross national product (GNP)
 GNP − net factor payments (NFP) = GDP

Question 17

 Private sector and government sector income

Answer 17

Private disposable income = income of the private sector = private sector income earned at
home (Y or GDP) and abroad (NFP) + payments from the government sector
(transfers, TR, and interest on government debt, INT) − taxes paid to government
 Private disposable income = Y + NFP + TR + INT − T (2.4)
 Government’s net income = taxes − transfers − interest payments = T − TR − INT (2.5)
 Private disposable income + government’s net income = GDP + NFP = GNP

Question 18

 The uses of private saving

Answer 18

 S = I + (NX + NFP) (2.9)
S = I + CA (2.10)
Derived from S = Y + NFP − C − G and Y = C + I + G + NX
CA = NX + NFP = current account balance
 Spvt = I + (−Sgovt) + CA (2.11)
{using S = Spvt + Sgovt}
The uses-of-saving identity—saving is used in three ways:
 Financing investment (I )
 Financing government budget deficit (−Sgovt)
 Stabilizing current account balance (CA)

Question 19

 Difference between Real GDP and Nominal GDP

Answer 19

Nominal variables are those in dollar terms
 Problem: do changes in nominal values reflect changes in prices or quantities?
 Real variables: adjust for price changes; reflect only quantity changes
 Nominal GDP is the dollar value of an economy’s final output measured at current market
prices
 Real GDP is an estimate of the value of an economy’s final output, adjusting for changes
in the overall price level
 Real GDP is calculated by estimating the value of the economy’s final output with respect to
a fixed year known as the base year

Question 20

 Price Indexes

Answer 20

A price index measures the average level of prices for some specified set of goods and
services, relative to the prices in a specified base year
 GDP deflator = nominal GDP/real GDP × 100
 For the base year GDP deflator is always 100
 GDP deflator is a more broad measure of price index, reflecting prices of all goods and
services that comprise the GDP
 Consumer Price Index (CPI) is a narrow measure of price index, reflecting prices of only
consumer goods and services

Question 21

Inflation

Answer 21

Growth rate in any measure of price index between two years.
 Inflation is denoted by π
 Calculate inflation rate in current year from previous year: π t= (Pt − Pt-1)/Pt-1 x100

Question 22

 Real vs. nominal interest rates

Answer 22

Nominal interest rate: rate at which the nominal value of an asset increases over time
 Nominal interest rate is denoted by i, and inflation is denoted by π
 Real interest rate = i − π

Question 23

 The expected real interest rate

Answer 23

The expected real interest rate is given by r
 r = i - πe (2.13)
 If π = πe
, i.e. if our inflationary expectations are correct
 then expected real interest rate = real interest rate

Question 24

 Consumption and Saving

Answer 24

Desired consumption: consumption amount desired by households
 Desired national saving: level of national saving when consumption is at its desired level
Sd = Y − Cd − G (4.1)
 The consumption and saving decision of an individual
 A person can consume less than current income (saving is positive)
 A person can consume more than current income (saving is negative)
 Trade-off between current consumption and future consumption
 The price of 1 unit of current consumption is 1 + r units of future consumption,
where r is the real interest rate
 Consumption-smoothing motive: the desire to have a relatively even pattern of
consumption over time

Question 25

1. Effect of changes in current income

Answer 25

ncrease in current income: both consumption and saving increase (vice versa for
decrease in current income)
 Marginal propensity to consume (MPC) = fraction of additional current income
consumed in current period; between 0 and 1
 Marginal propensity to save (MPS) = fraction of additional current income saved in
current period; MPS = 1- MPC
 When current income (Y) rises, Cd and Sd rise based on the individual’s marginal
propensity to consume (MPC), and marginal propensity to save (MPS) respectively

Question 26

2. Effect of changes in expected future income

Answer 26

 Higher expected future income leads to more consumption today, so savings fall

Question 27

3. Effect of changes in wealth

Answer 27

 Increase in wealth leads to more consumption today, so savings fall

Question 28

4. Effect of changes in real interest rate

Answer 28

Increased real interest rate has two opposing effects:
 Substitution effect: Positive effect on saving, since rate of return is higher; greater
reward for saving elicits more saving
 Income effect
 For a saver: Negative effect on saving, since it takes less saving to obtain a given
amount in the future (target saving)
 For a borrower: Positive effect on saving, since the higher real interest rate
means a loss of wealth. Borrowing falls, or savings rise.

Question 29

5.1 Government Purchases (Temporary Increase)

Answer 29

Directly affects desired national saving, Sd = Y − Cd − G
 Higher G financed by higher current taxes reduces after-tax income, lowering
consumption today
 Even true if financed by higher future taxes, expected future income (after-tax) will
fall, lowering consumption today
 Since the decline in Cd is less than the rise in G, national saving (Sd = Y − Cd − G)
declines
 So government purchases reduce both desired consumption and desired national
saving

Question 30

5.2 Tax Cut

Answer 30

Lump-sum tax cut today, financed by higher taxes tomorrow
 Current income increases, future income will fall
 Decline in income tomorrow may offset increase in current income; desired
consumption could rise or fall
 Ricardian equivalence proposition
 If future income loss exactly offsets current income gain, no change in
consumption
 Tax change affects only the timing of taxes, not their ultimate amount
(present value)

Question 31

 Why is investment important?

Answer 31

Investment fluctuates sharply over the business cycle, so we need to understand
investment to understand the business cycle
 Investment plays a crucial role in economic growth

Question 32

 The desired capital stock

Answer 32

Desired capital stock is the amount of capital that allows firms to earn the largest
expected profit
 Desired capital stock depends on costs and benefits of additional capital
 The benefit of the desired capital stock is the expected future marginal product of capital
(MPKf
)
 The user cost of the desired capital stock includes the real interest cost + depreciation
cost i.e.,

Question 33

 Shifts of the saving and investment curve:

Answer 33

When the level of savings or investment change due to factors other than the real interest
rate, it leads to the entire shift if the savings or investment curves

Question 34

 Definition of Steady states

Answer 34

In the steady state total output, total consumption, total capital stock, and total workforce
i.e, Yt, Ct, Kt , and Nt are all growing at a rate n
 Therefore, in the steady state: output per worker, consumption per worker, and capital
per worker are not growing. This means that yt, ct, and kt are constant overtime.

Question 35

 Why do emerging markets grow faster than developed countries

Answer 35

• Because emerging countries have already almost to the golden rule level of capital and don’t have much to improve on while emerging markets have a lot of growth to do

Question 36

 What are the determinates of economic growth in the solow growth model

Answer 36

• Increase the savings rate in the country (s)  Shift up in the savings curve
• Reduce the population growth rate (n)  Investment curve flattens (same origin)
o If the rate dips too low, you will be left with too low of a productive labor force
• Technological innovation (total factor productivity growth (TFPG))  Shift up in the savings curve (Japan, US, UK)

Question 37

o Policies to raise the rate of productivity growth

Answer 37

 Improve infrastructure
 Increase human capital
 Increase R&D